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Concept of leverages

Leverage is defined as a technique in finance to multiple gains and losses.  The most general and common ways of attaining leverage are borrowing money, buying fixed assets and using derivatives. Before we go ahead with the concept of Leverages, consider the following example – Let us assume there are two companies A and B which are exactly similar to each other in terms of nature of business, size, extent of turnover etc. As such, the amount of capitalization is also the same for both the companies which is assumed to be $ 10,000. However, strategies for raising the capital are different from each other. Assuming that the required capital can be raised either by way of equity or debt, following particulars are available:

  Company A
     Company B
Equity share capital 
(each share of $ 10 each) 1,000 9,000
10% debentures 9,000 1,000
  10,000 10,000

Profitability statements of both the companies when sales are $ 20,000 and $ 18,000 are as below:

  Company A Company B
Sales 20,000 18,000 20,000 18,000
Less: Variable Cost
10,000 9,000 10,000 9,000
Contribution 10,000 9,000 10,000 9,000
Less: Fixed Cost 5,000 5,000 5,000 5,000
PBIT 5,000 4,000 5,000 4,000
Less: Interest 900 900 100 100
PBT 4,100 3,100 4,900 3,900
Less: Income Tax @ 50% 2,050 1,550 2,450 1,950
PBT 2,050 1,550 2,450 1,950
Number of equity shares 100 100 900 900
Earnings per share 20.50 15.50 2.72 2.16

It can be noted from the above example that A Ltd. Is able to earn more amount per equity share because in its capital strucutre the amount of debentures is more and also because the interest paid on debentures is tax deductible expenditure and amount of tax is less in case of A Ltd.
It can also be noted from above example that a 10% reduction in sales in case of A Ltd. Reduces the earnings per share by around 24% while the same percentage of reduction in sales in case of B Ltd. Reduces the earnings per share by around 20%. It happens so because the risk of reduction in sales and earnings gets disturbed among less number of equity shares in case of company A Ltd. While the said risk disturbed among more number of equity shares in case o fcompany B Ltd.

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